A Business life cycle is fluctuations or up and down movements in the real GDP along its long term growth trend as shown below;
There are four phases in a business life cycle, expansion, peak, contraction or recession and trough. GDP and other macroeconomic indicators like jobs, sales define the phase in which the economy is.
Expansion or expansionary Phase of the business life cycle
Between trough and peak the economy is an expansionary phase of the business life cycle which is the normal phase for an economy to be in. The expansionary phase is characterized by increasing real GDP and decreasing unemployment. The fiscal and monetary policies are expansionary, i.e. the government increases spending and reduces taxes and the interest rates are low. The result is an increase in consumer spending and business investment. There is an increase in imports as the consumers have more disposable incomes to spend and also the currency during this phase is generally appreciating.
Peak of the expansionary phase
As the expansionary phase reaches its peak, the economy is operating at full capacity which results in increasing inflationary pressure and inflation accelerates. (You can read more about inflation here.) In a bid to reign in the inflation, the fiscal and monetary policies are not expansionary anymore and the government spending slows down and taxes increase and interest rates are hiked (To read about fiscal and monetary policies and how they are employed you can read the previous post where they have been covered in quite a bit of detail). The result is a stagnating economy. The real GDP, employment, consumer spending and business investment grow but at a decreasing rate.
Contraction or contracting phase of the business life cycle
This eventually leads to the third phase of the business life cycle which is the contraction phase where the economy starts to contract. The real GDP is negative. The contraction phase is confirmed when GDP is negative for two consecutive quarters. Unemployment increases and there is a decline in consumer spending and business investment. Interest rates are still high. Imports decline as the disposable incomes decrease and also the currency is generally depreciating in this phase. Inflation starts to come off but with a lag.
Trough of the contraction phase of the business life cycle
As the contraction phase reaches its trough, inflation has come off and interest rates are being reduced and government is increasing its spending once again in a bid to stimulate the economy. The result is a recovery as the economy turns the corner and real GDP is positive again. Unemployment is still high at this stage. However consumer spending on durables and housing is gradually showing signs of increasing.
This cycle from trough to peak constitutes a whole business or economic life cycle. Business life cycles recur but not at regular intervals. A business life cycle can be as short as a year or as long as a decade.
That’s all in this post …..
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over the next few posts we will cover the indicators of business cycles, and the fall out of business cycles i.e. inflation. We will also look closely into cost push and demand pull inflation and what causes them occur in certain phases of business cycles….so stay tuned…there’s a lot coming up….
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For solved examples please refer to the CFA Institute Books or any other study notes that provide them and you may want to use. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.